An Investor Should Expect to Receive a Risk Premium for Taking on Market Risks

Investors take on risk with the expectation of earning a return that justifies the uncertainty. The risk premium explains why riskier assets tend to offer greater potential rewards. Without this compensation, investors would have little incentive to allocate capital toward uncertain ventures rather than safer alternatives.

This additional return is influenced by factors that increase investment risk. Understanding these risks helps investors make informed decisions about where to place their money and what level of volatility they are willing to tolerate.

Higher Volatility

Stock prices fluctuate daily, but some investments experience far greater swings. Sectors like technology and biotechnology often see sharp movements due to rapid innovation cycles, regulatory changes, and shifting consumer demand. A pharmaceutical company awaiting FDA approval for a new drug may see its stock price double on positive news or collapse if the drug is rejected. These unpredictable price movements create opportunities for higher returns but also expose investors to greater downside risk.

Market sentiment amplifies volatility. Optimistic investors may push prices beyond fundamentals, only for a shift in sentiment to trigger a sharp sell-off. The 2021 surge in GameStop’s stock, fueled by social media speculation, led to extreme price swings unrelated to the company’s financial health. Some traders profited, while others suffered steep losses when the hype faded.

Leverage further intensifies volatility. Investors using margin accounts borrow money to increase their positions, which can lead to exaggerated price movements. If a stock declines sharply, margin calls force investors to sell, accelerating the downturn. This was evident in the 2008 financial crisis when excessive leverage in mortgage-backed securities contributed to widespread market turmoil.

Illiquid Securities

Investments that lack an active market can be difficult to buy or sell without significantly impacting their price. Unlike publicly traded stocks, which have continuous trading volume, illiquid assets may take days, weeks, or even months to offload. This lack of liquidity forces investors to accept a higher risk premium, as they may be unable to exit a position quickly if market conditions change.

Real estate exemplifies this challenge. A commercial property might take months to sell, especially in a weak economy or when financing costs rise. Even if an investor is willing to sell at a discount, finding a buyer at the right price can be difficult. Private equity investments face similar issues, as shares in a privately held company cannot be easily liquidated without a lengthy negotiation process.

Certain bonds also suffer from illiquidity. Municipal bonds, for instance, often trade infrequently, leading to wide bid-ask spreads. Investors looking to sell before maturity may receive less than the bond’s intrinsic value due to the lack of willing buyers. High-yield corporate bonds, particularly those issued by smaller companies, can experience similar pricing inefficiencies, making it costly to exit a position prematurely.

Uncertain Economic Environments

Fluctuating economic conditions introduce unpredictability that affects investment returns. Periods of growth often lead to rising corporate earnings, increased consumer spending, and expanding credit availability, all of which support asset price appreciation. Conversely, downturns can result in declining revenues, tighter lending standards, and reduced investor confidence, making it more challenging for businesses to secure financing or maintain profitability.

Interest rate changes shape economic conditions. When central banks adjust benchmark rates, borrowing costs shift accordingly. Rising rates increase the cost of debt for companies and individuals, which can slow economic activity and weigh on corporate valuations. Declining rates encourage borrowing and investment but may signal underlying economic weakness. The uncertainty surrounding future rate movements creates volatility in fixed-income markets, as investors reassess the attractiveness of bonds relative to equities.

Inflation complicates investment decisions. When inflation accelerates, purchasing power erodes, and businesses face higher input costs. Companies with strong pricing power can pass these costs onto consumers, but those in competitive industries may struggle to maintain margins. Inflation-linked securities, such as Treasury Inflation-Protected Securities (TIPS), offer a hedge against rising prices, but other assets, like long-term bonds, can suffer as higher inflation expectations push yields upward.

Political Instability

Government actions and geopolitical tensions create uncertainty that directly affects investment returns. Policy shifts, trade disputes, and regulatory overhauls can alter the profitability of entire industries overnight. When a country imposes new tariffs or trade restrictions, companies reliant on global supply chains may see costs rise and revenues decline, prompting investors to demand higher returns for the added unpredictability. The U.S.-China trade war, for example, led to market volatility as tariffs disrupted supply chains and forced businesses to adjust strategies.

Political risk extends beyond trade policy. Nationalization of industries, abrupt changes in tax structures, and capital controls can erode investor confidence. Emerging markets are particularly susceptible, as governments with weaker institutional frameworks may enact drastic measures with little warning. Venezuela’s nationalization of oil assets significantly impacted foreign investors, while India’s 2016 demonetization policy abruptly invalidated large banknotes, disrupting cash-dependent businesses and causing short-term economic turbulence.

Elections introduce another layer of uncertainty. Shifts in leadership often bring changes in fiscal policy, corporate taxation, and government spending priorities. Investors analyze proposed policies to anticipate potential market impacts, as seen in the 2020 U.S. presidential race, where differing tax plans created uncertainty for high-income investors and corporations.